A 25 basis points repo rate hike in the October monetary policy committee (MPC) meeting is our baseline expectation. Amid higher oil prices and a rapid weakening of the Indian rupee, we expect the MPC to tilt towards greater caution with the objective of containing aggregate demand as well as pushing real interest rates higher. As regards their stance on liquidity, the committee seems to be stuck between the proverbial rock and the hard place. On the one hand, the Indian rupee has fallen rapidly to beyond 72.50 against the US dollar from less than 68.50 at the time of the previous MPC meeting in early August. Traditional monetary theory would suggest RBI to keep rupee liquidity in check to contain potential speculative pressures against the domestic currency. On the other hand, the more recent bout of sharp volatility in Indian equity market, specifically for segments of financial companies facing liquidity stress, would demand the central bank to offer greater support to money market liquidity in the near term.
Consumer Price Index (CPI)-based inflation—formally the MPC’s key target variable as per the inflation targeting mandate—is markedly low at present and is set to stay benign over the next 3-6 months. However, we feel that the committee will remain particularly watchful on two factors and will likely adopt a more cautious stance. First, the recent surge in oil prices—the Brent crude price currently stands at around $82/ barrel versus about $72/barrel at the time of the previous MPC meeting. Second, as mentioned above, the rapid weakening in the rupee. Both the factors, ceteris paribus, will adversely impact RBI’s 6-12 month forward inflation expectations. We expect CPI inflation to average above 5% during Q2-Q3 2019 (April-September); a level higher than the MPC’s oft-emphasised central point of inflation target (ie., 4%). The continued tightening bias of central banks—for example, the US Fed as well as a number of emerging market peers—may also influence the RBI’s decision next week.
However, we expect tightening by the MPC to be calibrated rather than aggressive. For instance, a 50bps hike in the repo rate in October enjoys low probability in our view. RBI’s communication suggests that the primary focus of monetary policy remains inflation targeting rather than managing the exchange rate. As such, despite the recent weakness in rupee, the expected level of CPI inflation over the next 6-12 months remains only modestly higher than the MPC’s desired level and well within its tolerance band. Apart from the likely rate action, the October MPC will be watched closely for (a) the committee’s stance on monetary policy—that is, whether the current “neutral” stance changes into a more restrictive one, for example, “withdrawal of accommodation” and (b) guidance, if any, on banking system liquidity.
Separately, in the context of exchange rate, we see limited options in Indian policy-makers’ toolkit to insulate the rupee from global tides at the moment. We feel that the RBI’s forex market intervention will primarily target curbing excessive volatility rather than aggressively targeting of a level for the exchange rate. Monetary policy is unlikely to be harsh, given that a spell of harsh monetary tightening against a somewhat similar backdrop of rapid rupee weakness in 2013 turned out to be ineffective, if not counter-productive. Attracting foreign-currency deposits from NRIs is a powerful policy option and could turn the tide for the rupee. However, we believe that the bar for implementing this option is very high. In sum, we feel that given the limited policy options in the hands of the authorities, the Indian rupee will likely remain exposed to the ebbs and flows of global tides in the near term.
Siddhartha Sanyal is chief India economist at Barclays Bank Plc.